What Are Real Business Cycles?

The real business cycle model is often described as the core of modern business cycle research. What this means is that other business cycle models have the RBC model as a special case (i.e. strip away all of the frictions from your model and its an RBC model). The idea that the RBC model is the core of modern business cycle research is somewhat tautological since the RBC model is just a neoclassical model without any frictions. Thus, if we start with a model with frictions and take those frictions away, we have a frictionless model.

The purpose of the original RBC models was not necessarily to argue that these models represented an accurate portrayal of the business cycle, but rather to see how much of the business cycle could be explained without the appeal to frictions. The basic idea is that there could be shocks to tastes and/or technology and that these changes could cause fluctuations in economic activity. Furthermore, since the RBC model was a frictionless model, any such fluctuations would be efficient. This conclusion was important. We typically think of recessions as being inefficient and costly. If this is true, countercyclical policy could be welfare-increasing. However, if the world can be adequately explained by the RBC model, then economic fluctuations represent efficient responses to unexpected changes in tastes and technology. There is no role for countercyclical policy.

There were two critical responses to RBC models. The first criticism was that the model was too simple. The crux of this argument is that if one estimated changes in total factor productivity (TFP; technology in the RBC model) using something like the Solow residual and plugged this into the model, one might be misled into thinking the model had greater predictive power than it did in reality. The basic idea is that the Solow residual is, as the name implies, a residual. Thus, this measure of TFP only captured fluctuations in output that were not explained by changes in labor and capital. Since there are a lot of things besides technology that might effect output other than labor and capital, this might not be a good measure of TFP and might result in attributing a greater percentage of fluctuations to TFP than was true of the actual data generating process.

The second critical response was largely to ridicule and make fun of the model. For example, Franco Modigliani once quipped that RBC-type models were akin to assuming that business cycles were mass outbreaks of laziness. Others would criticize the theory by stating that recessions must be periods of time when society collectively forgets how to use technology. And recently, Paul Romer has suggested that technology shocks be relabeled as phlogiston shocks.

These latter criticisms are certainly witty and no doubt the source of laughter in seminar rooms. Unfortunately, these latter criticisms obscure the more important criticisms. More importantly, however, they represent a misunderstanding of what the RBC model is about. As a result, I would like to provide an interpretation of the RBC model and then discuss more substantive criticisms.

The idea behind the real business cycle model is that fluctuations in aggregate productivity are the cause of economic fluctuations. If all firms are identical, then any decline in aggregate productivity must be a decline in the productivity of all the individual firms. But why would firms become less productive? To me, this seems to be the wrong way to interpret the model. My preferred interpretation is as follows. Suppose that you have a bunch of different firms producing different goods and these firms have different levels of productivity. In this case, an aggregate productivity shock is simply the reallocation from high productivity firms to low productivity firms or vice versa. As long as we think of all markets as being competitive, then the RBC model is just a reduced form version of what I’ve just described. In other words, the RBC model essentially suggests that fluctuations in the economy are driven by the reallocation of inputs between firms with different levels of productivity, but since markets are efficient we don’t need to get into the weeds of this reallocation in the model and can simply focus our attention on a representative firm and aggregate productivity.

I think that my interpretation is important for a couple of reasons. First, it suggests that while “forgetting how to use technology” might get chuckles in the seminar room, it is not particularly useful for thinking about productivity shocks. Second, and more importantly, this interpretation allows for further analysis. For example, how often do we see such reallocation between high productivity firms and low productivity firms? How well do such reallocations line up with business cycles in the data? What are the sources of reallocation? For example, if the reallocation is due to changes in demographics and/or preferences, then these reallocations could be interpreted as efficient responses to structural changes in the economy and be seen as efficient. However, if these reallocations are caused by changes in relative prices due to, say, monetary policy, then the welfare and policy implications are much different.

Thus, to me, rather than denigrate RBC theory, what we should do is try to disaggregate productivity, determine what causes reallocation, and try to assess whether this is an efficient reallocation or should really be considered misallocation. The good news is that economists are already doing this (here and here, for example). Unfortunately, you hear more sneering and name-calling in popular discussions than you do about this interesting and important work.

Finally, I should note that I think one of the reasons that the real business cycle model has been such a point of controversy is that it implies that recessions are efficient responses to fluctuations in productivity and counter-cyclical policy is unnecessary. This notion violates the prior beliefs of a great number of economists. As a result, I think that many of these economists are therefore willing to dismiss RBC out of hand. Nonetheless, while I myself am not inclined to think that recessions are simply efficient responses to taste and technology changes, I do think that this starting point is useful as a thought exercise. Using an RBC model as a starting point to thinking about recessions forces one to think about the potential sources of inefficiencies, how to test the magnitude of such effects, and the appropriate policy response. The better we are able to disaggregate fluctuations in productivity, the more we should be able to learn about fluctuations in aggregate productivity and the more we might be able to learn about the driving forces of recessions.

In my economics text book 7 reasons for business cycles are given but they are all of insufficient generality to properly explain the cause of them and their cure. The only really good explanation I have see is the one provided by Henry George (“Progress and Poverty” 1879, still in print) where the speculation in land values eventually becomes so extreme that the business of construction of homes and workplaces fails to be worthwhile. Then the heavily debt-bearing system breaks down (as in 2007) only to begin a new cycle of 18 years duration. George supplies a solution to it for providing stability too.

Romer’s criticism is that there is no substantive, economic content to the the phrase “technology shock” or “preference shock”. No on can describe what those things might be sufficiently clearly to model them as an endogenous process. That critique is not dumb at all, even it it is funny.

Excellent article, Thank you… Currently the variance in productivity among firms even in individual industries is increasing. My view is that it relates to having low interest rates for many years which has given a life line to low productive firms. Essentially Creative Destruction has been suppressed. I think you tempt us with that idea above when you mention monetary policy. Well written.

Thanks! I actually just had a paper accepted in which we present a model that suggests that when real interest rates are low, low productivity firms are more likely to stay in the market. I’m still trying to work out a good way to test this empirically.

I’ve always had a problem with “shocks”. Nobody defines the magnitude of endogenous variations above which +/- variation becomes a “shock”. Furthermore, if the endogenous variations are generally Gaussian, then how can any one of them be described as a “shock” without arbitrarily setting a threshold at +/- x standard deviations.

Your defense of RBC sounds reasonable but also seems to be unconnected to reality. For example consider the recession in 2000. It was not caused by monetary policy which did not change. So you suggest “reallocation… due to changes in demographics and/or preferences” But the recession hit in a matter of weeks in March 2000, and demographics don’t change that fast. This leaves preferences. But we can always get any result we want by assuming changes in “preferences” (utility function etc.).

So what good does RBC do us here? We don’t need any “frictions” but all the “explanatory” work is being done by an undisclosed theory of preference change or something similarly content free.

RBC could be interesting IF it included a theory of “shocks”. Unfortunately it doesn’t, so “shock” is really just an empty term for “postulated exogenous variations that drive the changes we’re trying to explain”. But putting it that way makes the emptiness obvious.

While as you say you are not “inclined” to agree with the RBC view of business cycles, you don’t really highlight the emptiness of the RBC definition of shock, or provide us with any description of proposed theories of shocks — which is where all the scientific content (if any) must be.

Your explanation at least has the virtue of making the ideological motivation fairly clear. If we can come up with a frictionless model that describes the phenomena then we can say it is efficient and government intervention is superfluous!